Inflation and Business

Inflation reflects the value of money at any point in time. It is a natural phenomenon in any economy, though the government would prefer to keep the inflation rate low rather than high. Read along to find out why this is the case, and how inflation may impact consumers, businesses, and society as a whole.

Inflation and Business Inflation and Business

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Table of contents

    What is inflation?

    The general increase in price over time is known as inflation.

    Inflation is measured using an index such as the Consumer Price Index (CPI), which here shows how the price of an average basket of goods changes over time.

    Consumer Price Index (CPI) measures the change in prices of a basket of goods over time.

    A basket of goods is a general set of goods and services that consumers use on a daily basis. A typical basket of goods might include basic food and beverages (e.g., bread, coffee, milk), furniture, housing, transportation, education, healthcare services, etc.

    As prices of the products in a basket of goods constantly change to match consumer habits in an economy, they can be tracked to measure the rate of inflation.

    CPI = of Basket of Goods in Given Year of Basket of Goods in Base Year x 100

    The rate of inflation is expressed as a percentage. For example, an annual 3% inflation rate means that a good priced at £100 last year would now cost £103.

    To calculate the inflation rate:

    Inflation % = Current CPI- Initial CPICurrent CPI x 100

    A box of milk costs 60p in 2010 and 80p in 2022. What is the inflation rate of the milk’s price between 2010 and 2022?

    Inflation rate = 80 - 6060 x100 = 33,33%

    The inflation rate is 33.33%.

    Inflation and business UK inflation rate StudySmarterFig. 1 - UK Inflation Rate 2010-2020. Source: UK Office for National Statistics

    Inflation and Business: Effect of inflation on consumers

    Inflation reduces consumer purchasing power since it takes more money to buy the product now than it did in the past. If people’s incomes fail to keep up with the rise in average price levels, the inflation rate, and consumer spending will drop, resulting in lower demand and sales revenues for businesses.

    To find out more about the factors that influence consumer spending, take a look at our explanation called Consumer spending effects on business!

    An extreme case of inflation is hyperinflation.

    Hyperinflation happens when prices increase rapidly and erratically, usually at a rate exceeding 50% per month.

    Hyperinflation often takes place during financial crises or war times when the central bank prints an excessive amount of money. With the supply of money exceeding the demand, the value of money drops, causing a surge in the prices of goods and services. As the prices of necessities such as flour, meat, and fuel skyrocket, people can no longer pay for their standard living needs. The economy will suffer from poverty, unemployment, and many other social issues.

    Lebanon's liquidity crisis is an example of hyperinflation, as the monthly inflation rate of the country stood at 131% in September 2020. One year later, the figure amounted to 144.12%. Inflation significantly reduced people's purchasing power, leading to the closure of many businesses and a nationwide power cut. At one point, the price of sugar in Lebanon saw a 670% increase while wheat, tea, rice rose by 1000% during the period. Many Lebanese people are experiencing extreme poverty since they can no longer afford basic goods.1

    Effect of inflation on business

    With inflation, employees will need a higher income to pay for daily expenses. They may ask for a pay rise, which results in higher costs for businesses. These costs will be transferred to the consumers in terms of higher prices, which adds to inflation.

    People will spend more as their income increases. Thus, to stimulate spending, the government can increase the minimum wage so that businesses have to pay their employees more. However, more wages also mean higher prices of goods and services, which leads to inflation. This is known as wage push inflation. If the increase in income does not match inflation, people's real wages will drop and they will have less money to spend on products and services. This means lower sales revenues for the company.

    Inflation also has an impact on international trade. Supposing the inflation rate is higher in the UK, goods produced by UK manufacturers will become more expensive compared to other countries. This will reduce their competitiveness and demand in the global market.

    In the following sections, you will see the positive and negative outcomes of inflation on business:

    Positive effects of inflation on business

    A low level of inflation can have many positive impacts on the performance of businesses.

    First, with inflation, companies can sell their products at a higher price and generate more revenues. This means more profits to be distributed among shareholders.

    Second, inflation encourages people to take out more loans, as they can repay the money at a lesser rate than they borrow. The increase in borrowing and lending activities will lead to an overall increase in spending and economic growth.

    Both individuals and businesses may take advantage of inflation to borrow money and invest in new machinery for higher productivity. Higher productivity will result in more output, which requires companies to hire more workers. Thus, inflation can contribute to an increase in jobs in an economy.

    Negative effects of inflation on businesses

    However, inflation is not always beneficial to an economy. A high rate of inflation can have many implications on business performance.

    First of all, a higher inflation rate means that people’s real income (income after taking into account inflation) will drop, causing them to spend less money on goods and services, which results in lower demand and lower sales for businesses.

    Without capital reserve in times of falling demands, businesses will not be able to pay for daily expenses and eventually go bankrupt. Lower business earnings also mean fewer tax revenues for the government, causing a delay in public projects and reduced social welfare.

    In addition, when the price levels increase drastically, people may be unsure about the future and start making speculative investments - the investment in assets such as real estate, stocks, gold, etc., to make quick profits under the assumption that the price will continue to rise.

    The problem with speculative investment is that the market can burst anytime, leaving investors with much less money than what they had originally invested. Businesses should assess the market carefully during inflation to avoid devastating outcomes of excessive speculation.

    Tulipmania is a good reminder of failing speculative investment. With the increasing demand for tulip flowers, people sought to acquire tulip contracts to re-sell for a higher profit. At one point, the price of tulips was so high that it cost 10 times the average salary of a Dutch worker. However, by the end of 1638, when people realised they could no longer afford overpriced tulips, the demand faltered, leaving multiple investors with tulips that cost only a small fraction of the price they purchased them for.

    Inflation will also put lenders in a worse financial position as they receive less money than they have lent out. For companies that issue bonds, inflation is the worst enemy. With higher inflation, investors will demand higher yields from companies to compensate for the loss in purchasing power caused by inflation.

    Bonds are loans that are issued by a company or a government to raise money for expenses and investment. In return, the investors will receive a fixed income, known as a coupon.

    Finally, inflation can cause the price of exports items to rise, which lowers their demand in the global market and less revenue for the home country.

    Advantages of inflation on businessesDisadvantages of inflation on businesses
    Higher product prices and revenuesLower demand for company's goods and services
    More possibility to borrow loans for investmentFalling sales and production output
    Higher productivity due to investment in machinery Risk of speculative investment
    Higher company outputHigher bond payments
    Higher profits and dividend payments for shareholdersLower demand for exported items
    Figure 1. Positive and negative effects of inflation on business

    Effects of low inflation on business

    Low inflation is a favourable situation for businesses and can result in:

    • Higher exports value since the prices are lower and more competitive

    • More investment by firms as they can take advantage of low inflation to borrow more money

    • More real income and purchasing power for the employees

    • Economic growth as the level of spending and output increases.

    A fall in inflation between the 1990s - 2000s brought many benefits to the UK economy:

    • More competitive goods and services
    • More investment by firms for growth and expansion
    • Lower menu costs
    • Higher interest rates for savers
    • High real wages for employees.2

    Over the course of time, the price of goods and services will increase. This is known as inflation. Inflation is a natural phenomenon in any economy and can have both negative and positive impacts on businesses and consumers. Usually, a low rate of inflation is positive, as it increases real wages, leading to more consumption and demand for goods. As demand increases, businesses can generate more revenues, increase their output and hire more people.

    Inflation and Business - Key takeaways

    • Inflation is the general increase in the price of goods and services over time. It can be measured using Consumer Price Index (CPI).
    • For consumers, inflation can reduce purchasing power and real income, meaning they will have less money to purchase goods and services. Inflation can also result in more expensive goods for consumers.
    • For businesses, inflation can have both a positive and negative impact.
    • The positives of inflation include higher revenues and profits, more possibility to borrow money, more investment for growth and expansion, and higher productivity and company output.
    • The negatives of inflation include lower demand for goods and services, falling revenues and production, lower demand for exported items, higher bond payments, and risk of business failure due to excessive speculation.

    Source:

    1. Lebanon’s Inflation Rate reached 144.12% by September 2021, Blomiminvest Bank, 2021.

    2. Philip Aldrick, 1990s Lesson: Recession Is The Price of Curbing U.K. Inflation, Bloomberg, 2022.


    References

    1. Fig. 1 - UK Inflation Rate 2010-2020. Source: UK Office for National Statistics, Consumer price inflation time series (MM23), 2010 - 2020, https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/l55o/mm23

    Test your knowledge with multiple choice flashcards

    What are the benefits of a low inflation rate on businesses?

    What are the negative impacts of high inflation on business?

    Hyperinflation happens when prices increase rapidly and erratically, usually at a rate exceeding ___ per month.  

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